Please cite to the respective author of this journal article: Chou, T.K. (2012). An Examination of the Mechanism and Legal Regulation Assuring Audit Independence. UC David Business Law Journal, 12: 225-242.
An Examination of the Mechanism and Legal Regulation Assuring Audit Independence
1. An Examination of the
Mechanism and Legal Regulation
Assuring Audit Independence
presented by Renzo Del Giudice (洛洛⼦子謙) - DA7G204
Southern Taiwan University of Science and Technology - Ph.D. in Business and Management - Seminar in Capital Market and Corporate Governance
2. Article citation:
• Chou, T.K. (2012). An Examination of the Mechanism and
Legal Regulation Assuring Audit Independence. UC David
Business Law Journal, 12: 225-242.
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3. Agenda
1. Introduction
2. The Business Model of the Accounting Industry and the
Embedded Conflict of Interest
3. Mechanism Evolution and Legal Requirement Assuring
Audit Independence
4. Effectiveness and Feasibility of the Current Regulation
Framework
5. Conclusion
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4. • Accounting Firms & Auditors: not completely independent from clients -
there’s a fee payment-, audit independence is an ideal (Green, 2008).
• Capitalism & Financial Markets need independent auditory, public confidence
in financial information is the keystone of financial markets. No confidence =>
no investment / Confidence => capital flow.
• Independent Auditors: have a vital function in capitalism, verifying the
accuracy of financial health of companies. Their function must be paired with
trust from investing public.
• Legal Framework: United States vs. Arthur Young (1984), and Sabarnes-
Oxley Act (2002).
1. Introduction 2. Accounting Industry 3. Audit Independence 4. Current Regulation 5. Conclusion
An Examination of the Mechanism and Legal Regulation Assuring Audit Independence - Renzo Del Giudice
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5. A. Audit Business
• It is the most important function from accounting industry.
• Dates back from 13th century, regulation started with the Securities Act ,1933
(companies must obtain an opinion form auditor before issuing stock), and
the Securities and Exchange Act, 1934 (companies must file audited financial
statements), creating basic information disclosure and huge business for
accounting industry.
• Companies obtain access to capital markets, investing public gains
confidence in disclosed financial information to formulate investment
decisions.
1. Introduction
2. Accounting
Industry
3. Audit Independence 4. Current Regulation 5. Conclusion
An Examination of the Mechanism and Legal Regulation Assuring Audit Independence - Renzo Del Giudice
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6. B. Embedded Conflict of Interest
• Auditor-Client relationship is born of a conflict of interest: audit services
requirements vs. audit service quality (audit paradox).
• E.g: auditor finds off-balance finance operations => auditor requires
company to correct accounting records => company expects auditor to
overlook discrepancies =>adjusting accounting records might affect stock
price => company prefers a no thorough review.
• Good quality audition: clients are subject of rigorous examination, but
auditors may lose clients.
• Auditors’ duty is to the public, not to the client (Kendall, 2004).
1. Introduction
2. Accounting
Industry
3. Audit Independence 4. Current Regulation 5. Conclusion
An Examination of the Mechanism and Legal Regulation Assuring Audit Independence - Renzo Del Giudice
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7. C. Non-audit Services and Changing Market Circumstances
• Auditors are competent to provide non-audit services (taxation, internal audit,
pension plans, information systems, etc.), e.g. = Andersen, Chicago 1913.
• Late 80’s: accounting firms becoming business advisory service firms. 90’s
N-AS = 50% revenue from 5 largest accounting firms (AS = 13% revenue).
Audit as a commodity, sold at low price to built good relationship with clients.
• Accounting Firm Dilemma: Price competition - no good profit from audit
service => audit becoming less attractive => rely on N-AS as profit source.
This goes against audit independence.
• Auditors “from scrupulous watchdogs to conciliatory lapdogs” (Cunningham,
2006), leading accounting industry into a degeneracy process.
1. Introduction
2. Accounting
Industry
3. Audit Independence 4. Current Regulation 5. Conclusion
An Examination of the Mechanism and Legal Regulation Assuring Audit Independence - Renzo Del Giudice
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8. • Mechanisms and legal framework adapted to the changing market: SEC
Regulation S-X (2000), and Sabarney-Oxley Act (2002).
• Pre SOX: Audit subjects to AICPA self regulation.
• Post SOX: Audit subjects to PCAOB independent regulation.
• Post SOX regulations are more complete and stringent, with PCAOB more
powerful and independent. However, conflicts of interest are not solved.
1. Introduction 2. Accounting Industry
3. Audit
Independence
4. Current Regulation 5. Conclusion
An Examination of the Mechanism and Legal Regulation Assuring Audit Independence - Renzo Del Giudice
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9. The current legislation is analyzed through Laws & Economic Analysis:
A. Society’s Costs
• Governmental and non-governmental expenses.
• Public companies’ expenses.
• Related social costs (Coase, 1960): negative externalities of public policies.
Post-SOX regulations = too strict, costly, and drive participants to move away
from U.S. Capital Market.
1. Introduction 2. Accounting Industry 3. Audit Independence
4. Current
Regulation
5. Conclusion
An Examination of the Mechanism and Legal Regulation Assuring Audit Independence - Renzo Del Giudice
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10. B. Violator’s Costs
• Sanctions: Social Responses (adverse publicity, reputation), and Legal
Processes (penalties, punishments, etc.).
• Formulation, procedures and veil violations expenses: coordination with
involved people and institutions to hide information from supervisors.
• The cost shows a near-horizontal total cost curve, costs of action don’t
increase with potential gains, and payment from supervision (PCAOB) is an
administrative expense.
1. Introduction 2. Accounting Industry 3. Audit Independence
4. Current
Regulation
5. Conclusion
An Examination of the Mechanism and Legal Regulation Assuring Audit Independence - Renzo Del Giudice
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11. C. Violator’s Benefits
• Accounting Frauds: made in order to meet expectations from the financial
market and personal interests from high-ranked managers. Responsibility is
on the auditor.
• Costs-savings stemming from audit efficiency and non-audit independence:
Providing N-AS = auditors get more knowledge of client, improving audit
efficiency. Companies get cheap and effective audit service => no N-AS
increases cost of AS => incentive to violate legal prohibitions.
1. Introduction 2. Accounting Industry 3. Audit Independence
4. Current
Regulation
5. Conclusion
An Examination of the Mechanism and Legal Regulation Assuring Audit Independence - Renzo Del Giudice
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12. D. Unbalanced Cost-Benefit Structure
1. Introduction 2. Accounting Industry 3. Audit Independence
4. Current
Regulation
5. Conclusion
An Examination of the Mechanism and Legal Regulation Assuring Audit Independence - Renzo Del Giudice
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Test Level Function Characteristics Satisfaction
1. Effectiveness Micro +LR = +VC,-(VB-VC)*
VB always higher than VC, which are treated
as administrative expenses (PCAOB
regulations). Not possible to stop violations.
No
2. Fairness
Micro /
Macro
+P ≠ NE**
Compliance affects: i) increasing auditing
costs, ii) drive companies out from the US
capital market. No initiatives to internalize
externalities
No
3. Worthiness Macro PSW > PTC*** Assumed to be true. N/A
*more legal requirements should increase violator’s costs, and diminish violator’s incentive (difference between benefits and costs).
**enforcing policy without creating negative externalities.
***policy social welfare greater than policy total cost.
13. • No solution for “Audit Paradox”.
• Due to its importance, the audit independence requires strong legislation to
construct a basis for the modern capitalist market.
• Post SOX era: improved legislation, but without effectiveness nor fairness.
• Current mechanism and legal framework are “quack corporate governance”.
• Accounting industry still struggle with corrections yet.
1. Introduction 2. Accounting Industry 3. Audit Independence 4. Current Regulation 5. Conclusion
An Examination of the Mechanism and Legal Regulation Assuring Audit Independence - Renzo Del Giudice
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15. II. Mechanism Evolution and Legal Requirements Assuring Audit Independence
A. Pre SOX Era B. Post SOX Era
1. Regulating Body
American Institute of Certified Public Accountants (AICPA).
a. Financial Standards Board (Set up GAAP).
b. Auditing Standards Board (Set up GAAS).
• Delegated by: Security Exchange Commission (SEC).
• Functions: Secure audit independence, setting accounting
standards, and oversee auditors of public companies.
Characteristics:
• FSB publications were funded by private donations.
• ASB members were predominately practicing
accountants.
• ASB auditor compliance ensured by peer review.
Concerns: Independence, integrity, fairness.
1. Regulating Body
Public Accounting Oversight Board (PCAOB).
• Delegated by: Congress of the U.S.A.
• Functions: to protect the interest from investors and public
in the preparations of audit reports from companies.
Characteristics:
• Non-profit private institution.
• Fundings from law established public companies
accounting fees.
• Membership is full time position, 5 members in service for
5 years and no reelection after two periods.
• Members are appointed by SEC, Federal Reserve, and
Secretary of Treasury.
Concerns: conflict of interest is still remaining.
2. Requirements for Audit Independence
Unclear rules
Before SEC Regulation S-X (2000)
• Non-audit services were not forbidden, only requesting
their disclosure.
• Standards and Rules: Code of Professional Conduct,
Codification of Statements of Auditing Standards.
After SEC Regulation S-X (2000)
• Certain non-auditing services with potential adverse
effects on audit independence were forbidden.
• Disclosure requirements were expanded.
• SEC was allowed to regulate auditors, finishing the ALCPA
self regulation.
2. Requirements for Audit Independence
Clear rules:
• Forbidden non-audit services: i) bookkeeping financial
statements, ii) implement of financial IS for clients, iii)
valuation services, iv) actuarial services, v) internal audit
outsourcing, vi) management or HR, vii) investment
banking services, viii) legal services, ix) other services
determined by PCAOB.
• Pre-approval for non-audit services.
• Auditors must submit reports about communications with
management to the audit committee.
• Auditors related to client companies preceding one year
are forbidden to provide audit services.
